Skip to main content
Sign In |
  Help (new window)

Global Tax Blog

Go Search
Home
  

Other Blogs
There are no items in this list.
Links
There are no items in this list.
Global Tax Blog > Categories

1/16/2013

Renewable energy and the ATRA of 2012
January 15, 2013
Tax Credit Alert
Author(s): Forrest Milder
 

This Nixon Peabody Alert discusses recent tax law changes resulting from the American Taxpayer Relief Act of 2012 (ATRA) that apply to renewables.

Change in the sunset for many (but not all) renewables. The act made a significant change to the production tax credit (PTC) and the investment tax credit (ITC) that applies to wind, geothermal that generates electricity, biomass, landfill gas, municipal solid waste, hydroelectric production, and marine and hydrokinetic energy.

Before ATRA, each of these technologies was eligible for a PTC or ITC only if the facility was placed in service by the end of 2013 (except wind, which had to be placed in service by the end of 2012, and geothermal, which can also qualify for a 10% credit beyond that date).

With long lead times, extensive requirements for approvals, and often long construction periods, having the credit depend on whether the facility is completed by a certain date made for a very high burden. Both developers and tax credit investors perceived these kinds of projects as much more difficult because of the risk that the credit could be lost by the time the project was completed. 

ATRA addresses this issue head-on by changing the sunset provision to depend on when the facility begins construction, rather than when the facility is placed in service. Now, if one of the facilities described above begins construction by December 31, 2013, it will be eligible for the applicable PTC or the 30% investment tax credit. Obviously, this is a big change that should help developers trying to line up tax equity in the face of an extended approval process.

A few observations: 

  1. There is no legislative history or other guidance explaining what it means to “begin construction.”

  2. Many practitioners have suggested that the IRS adopt the standards set by Treasury for the 1603 grants in lieu of tax credits program, i.e.:

    1. the test of beginning physical work before the end of 2013 (and then continue to work on the project thereafter), and
    2. the test of accruing at least 5% of the cost of the project before the end of 2013.  
  3. Of course, Treasury’s guidance for these renewable technologies had three sunset provisions—an applicant had to begin construction by December 31, 2011; submit a preliminary (or final) application before October 1, 2012; and then place the facility in service by December 31, 2012, for wind, and December 31, 2013, for geothermal that generates electricity[1] biomass, landfill gas, municipal solid waste, hydroelectric production, and marine and hydrokinetic energy. On the other hand, the new ATRA extension for these kinds of renewables only has one sunset: Construction must have begun by December 31, 2013, so it won’t be surprising if the IRS seeks to impose some other limitations on the definition of “begun construction.”
  4. Accordingly, it may be better to wait until we hear something from the IRS. There are many possibilities—the IRS might require more than 5% be incurred in 2013, 5% plus diligently working to finish the project, that a particular project be identified before it is begun or the end of the year, or other variations. Until something is actually published by the IRS, it isn’t possible to determine what the standard might be. We’ll keep monitoring tax legislation and IRS regulations, looking for any rules or modifications to what we’ve seen so far.

Renewables that are still subject to the old rules. The tax credit rules for solar, fuel cells, small wind, microturbines, combined heat and power facilities, geothermal that generates heat, and geothermal that generates electricity, but that begins construction after 2013, continue to have the same placed-in-service tests as before ATRA. For example, solar facilities must still be placed in service by the end of 2016 to qualify for the 30% ITC. Industry groups are continuing to seek a “begun construction” rule here as well for those projects with very long lead times.

Section 1603 grants. No changes were made to the Section 1603 grant program for any renewable technology. In particular, no change was made in the sunsets for grants. As a result, to qualify for a grant, a renewable facility still has to meet the three sunset provisions described above, with the addition of a later placed-in-service date for solar, fuel cells, small wind, microturbines, geothermal that generates heat, and geothermal that generates electricity but begins construction after 2013, and combined heat and power. To qualify for a grant, each of these must be placed in service before 2017. 

Sequestration. The sequestration rules, which OMB said would result in a 7.6% reduction in amounts paid under Section 1603, are still hanging over the industry. ATRA merely delays implementation by two months, from January 2, 2013, to March 1, 2013, leaving us wondering if the proposed percentage reduction in 1603 grant awards will still go into effect later this year. Again, industry groups are seeking an exemption for the Section 1603 grant program.

Technical fix: Facilities must be new. Most people didn’t realize that, when the American Recovery and Reinvestment Act of 2009 (ARRA) permitted PTC-eligible facilities to instead qualify for the ITC, and for any renewable facility to qualify for a 1603 grant, the legislation did not include the requirement that the facility be “new.” The ATRA legislation retroactively adds that requirement, dating back to ARRA. Of course, for this purpose, “new” generally means “80% new.” This means that a $10M wind project that uses $1.5M of used tower parts should still be considered new.

Other credits. Several other credits were also extended. The homeowner’s credit for energy-efficient homes (Section 25C of the Code), the credit for alternative fuel refueling property (Section 30C), the credit for two- or three-wheeled plug-in vehicles (Section 30D), and the business credits for energy-efficient homes (Section 45L) and appliances (Section 45M) all now include facilities placed in service in 2012 or 2013. Finally, in the case of residences, the reference to an efficiency standard has been updated from the International Energy Conservation Code of 2003 to the Code of 2006.

The credits for cellulosic biofuel, biodiesel, and renewable diesel are extended to apply to fuel production before January 1, 2014. Note that these credits and the corresponding extensions are based on the date of the production of the particular fuel, not the date that the facility is placed in service. In addition, cellulosic fuel is now called “second-generation biofuel,” and the definition is modified to include fuel derived from algae, cyanobacteria (a kind of bacteria that uses photosynthesis), and lemna (a kind of aquatic plant). Similar extensions are provided for the comparable alternative fuels excise tax credits in code sections 6426(d)(5) and (e)(3). Finally, there’s a one-year extension of the Indian coal credit, which is limited to certain facilities placed in service before 2006.

Bonus depreciation. ATRA extends “bonus depreciation” another year so the 50% bonus applies to property placed in service before January 1, 2014, and even January 1, 2015, for certain property. Second generation biofuels (described in the “Other credits” paragraph) have a similar 50% extender until the end of 2013. To illustrate, imagine a $1M facility that qualified for a 30% ITC to be claimed by its owner. The basis in that facility will be $850K (after reduction by half the amount of the $300K credit), and first-year depreciation will be the bonus, i.e., 50% of $850K (or $425K) plus regular 5-year accelerated depreciation, equal to 20% of the balance (or $85K), for a total first-year deduction of $510K. Note that the bonus rules automatically apply unless the taxpayer elects for them not to apply. Sometimes, particularly where there is a tax credit investor, having this much depreciation in one year can overwhelm the investor’s capital account and actually cause some deductions to be allocated to other partners or members, so the effect of bonus depreciation should be carefully monitored.

Special rules for certain utilities. Section 451(i) provides favorable tax rules for certain utilities that sell their property to implement FERC or a state restructuring policy. These rules are extended to apply to sales or other dispositions that occur before January 1, 2014.


  1. There’s also a 10% grant for geothermal placed in service by December 31, 2016.

For more information, contact your Nixon Peabody attorney or: Forrest Milder, fmilder@nixonpeabody.com

Download Alert

Posted at 9:02 AM by makeenan@nixonpeabody.com | Category: Individual Tax | Permalink | Email this Post | Comments (0)
The American Taxpayer Relief Act of 2012
January 15, 2013
Private Clients Alert

The American Taxpayer Relief Act of 2012, passed by both the House and Senate on New Year’s Day and signed into law by President Obama on January 3, 2013, addressed the revenue side of the so-called “Fiscal Cliff.” Still to come will be agreement on the expenditure side of the equation. This alert will summarize the key provisions of the Act that impact individual taxpayers.

Summary:

 The Act made a number of changes impacting individuals:

  • A permanent extension of the current income tax rates for individuals with taxable income under $400,000 ($450,000 for joint filers);
  • An increase in the top tax rate to 39.6% for individuals with taxable income over $400,000 ($450,000 for joint filers) and for taxable trusts with taxable income over $11,950;
  • A continuation of the preferential 15% tax rate for long-term capital gain and qualified dividend income for individuals with taxable income under $400,000 ($450,000 for joint filers);
  • An increase in the long-term capital gain and qualified dividend income tax rate to 20% for individuals with taxable income over $400,000 ($450,000 for joint filers);
  • A reinstatement of the itemized deduction limitation and personal exemption phase-out for individuals with adjusted gross income over $250,000 ($300,000 for joint filers);
  • A permanent increase in the alternative minimum tax (“AMT”) exemption amount (indexed for inflation);
  • A permanent extension of the estate, gift and generation skipping tax (“GST”) exemptions to $5 million per person (indexed for inflation - $5,250,000 for 2013), with an increase in the top tax rate to 40%;
  • An extension of a number of expired tax provisions such as the child tax credit, dependent care tax credit, adoption tax credit, student loan interest deduction, sales tax deduction, exclusion for employer provided education assistance, and the American opportunity tax credit for college tuition, among other items; and
  • An extension for tax-free distributions from IRAs to charities for qualified individuals, including an opportunity to transfer December, 2012, distributions to charities for a limited period.
  • Not extended was the payroll tax holiday which allowed employees a 2% FICA tax reduction for the past few years.
  • The Act also includes a number of business and energy tax provisions, including an extension of the bonus depreciation and expensing rules.
  • Although not part of the 2012 ATRA, 2013 is the first year that the new Medicare tax will apply to individuals with adjusted gross income over $200,000 ($250,000 for joint filers) at rates of 0.9% on net earned income and 3.8% on “net investment income.”

Explanation:

  1. Tax Rates – Ordinary Income – The tax rates and brackets set in place by 2001 and 2003 legislation (the “Bush Tax Cuts”) and scheduled to sunset at the end of 2010 were extended through 2012 by the current administration. There were six tax brackets – 10%, 15%, 25%, 28%, 33% and a top bracket of 35%.

    The 2012 ATRA eliminates the sunset rule, and therefore makes the tax brackets “permanent” in nature. Of course, permanency is a bit of a misnomer, because any aspect of the tax law may be changed any time Congress is in session. However, the elimination of the sunset provisions, which have been part of the tax landscape since 2001, does provide a bit more certainty for planning purposes, and is a welcome relief.

    The Act also adds a new top tax rate of 39.6% that will apply to single taxpayers with taxable income in excess of $400,000 and joint taxpayers with taxable income in excess of $450,000. The threshold for this new top rate is below the $1 million “Plan B” proposed by the House speaker, but $200,000 higher than the level sought by President Obama.

    As discussed in more detail below, the Medicare tax on earned and unearned income will also have a significant impact on marginal tax rates.

    The tax brackets applicable to single and joint individual taxpayers are listed below:

    2013 Individual Tax Rates

    Taxable Income

    Single Taxpayers

    Joint Filers

    Tax Rate

    $0–$8,925

    $0–$17,850

    10%

    $8,926–$36,250

    $17,851–$72,500

    15%

    $36,251–$87,850

    $72,501–$146,400

    25%

    $87,851–$183,250

    $146,401–$223,050

    28%

    $183,251–$398,350

    $223,051–$398,350

    33%

    $398,351–-$400,000

    $398,351–$450,000

    35%

    $400,001 +

    $451,001 +

    39.6%























    For example, assume a married couple filing a joint return reports $475,000 of taxable income. Their income up to $450,000 will be taxed under the 10% to 35% brackets listed above. Their remaining income of $25,000 (the amount exceeding $450,000) will be taxed at the new top tax rate of 39.6%.

    Taxable trusts have incredibly narrow tax brackets, and reach the top tax rate of 39.6% at $11,950 of taxable income. 

    Taking into account the 3.8% Medicare tax on net investment income and the approximately 1% impact of the itemized deduction and personal exemption phase-outs discussed below, the top combined federal marginal rate (not including state income tax) is approximately 44.4% for interest income, passive income, rents, annuities and short-term capital gain.

    For compensation income (salaries, wages and self-employment income), the top combined federal marginal rate, after considering the 0.9% additional Medicare rate and phase-out impact, is approximately 41.5%, not including state income tax.

  2. Tax Rates – Long-Term Capital Gain & Qualified Dividends – The preferential tax rate on long-term capital gain and qualified dividend income remains at 15% for taxpayers below the 39.6% threshold listed above—that is, single taxpayers with taxable income under $400,000 and joint filers with taxable income under $450,000. The 15% rate for long-term capital gain and qualified dividends was put in place by 2003 legislation and was expected to sunset in 2010, but it was extended through the end of 2012 as part of the extension of the Bush Tax Cuts. The 2003 legislation also instituted a 0% tax rate on long-term capital gain and qualified dividend income for taxpayers in the 10% or 15% ordinary income tax brackets. The Act continues this treatment for individuals in the two lowest tax brackets.

    For taxpayers with taxable income above $400,000 ($450,000 for joint filers), long-term capital gain and qualified dividends will be taxed at 20%.  

    A major concern prior to this new legislation was that qualified dividend income would lose its preferential tax rate and therefore be taxed at ordinary tax rates. This would have meant an increase from 15% to 39.6%, plus the 3.8% Medicare tax. Under ATRA, the qualified dividend preferential tax rate remains part of the permanent tax law.

    The new tax rates for long-term capital gain and qualified dividends are based on taxable income levels as follows: 

    Long-Term Capital Gain and Qualified Dividends

    Taxable Income

    Single Taxpayers

    Joint Filers

    Tax Rate

    $0–$36,250

    $0–$72,500

    0%

    $36,251–$400,000

    $72,501–$450,000

    15%

    $400,001 +

    $450,001 +

    20%


    For example, assume a single taxpayer has $420,000 of taxable income, comprised of $360,000 of salary income and $60,000 of qualified dividend income. Single taxpayers are subject to the top 39.6% ordinary tax rate at $400,000 of taxable income. Under the Act, part of the of the qualified dividend income will be subject to a 15% tax rate, and the remainder subject to the new 20% tax rate. The lesser of a) the $60,000 qualified dividend income or b) the taxable income not subject to the 39.6% tax rate ($400,000) less the taxable income reduced by the qualified dividend income ($360,000) or $40,000, is subject to the 15% rate, with the remaining $20,000 subject to the 20% rate.

    The top tax rate for a trust is reached at $11,950 of taxable income. Thus, qualified dividend income and long-term capital gain will, over this threshold, be subject to 20% taxation. 

    The Act also extends the 100% exclusion of gain on qualified small business stock acquired after September 27, 2010, and before January 1, 2014, and held for more than five years.

  3. Itemized Deduction Phase-out (Pease Limitation), Medical Deduction and Personal Exemption Phase-out (“PEP”)

    Itemized Deduction Phase-out    —The Itemized Deduction Limitation (“Pease Limitation”) is reinstated beginning with the 2013 tax year. Under this limitation, taxpayers’ itemized deductions will be reduced by 3% of the excess of their Adjusted Gross Incomes (“AGI”) over the threshold amounts for their specific filing statuses. Medical expenses, investment interest expenses, and casualty losses are not subject to the limitation, and the total reduction may not exceed 80% of allowable itemized deductions. The filing status threshold amounts are: $300,000 for joint filers, $275,000 for heads of households, $250,000 for single filers and $150,000 for married taxpayers filing separately. These thresholds will be adjusted for inflation for tax years after 2013.

    As an example, Taxpayer A is a single filer with an AGI of $450,000 and total itemized deductions of $120,000. He does not claim any medical expenses, investment interest expenses or casualty losses. The amount of his 2013 Pease Limitation is $6,000 ($450,000 AGI minus $250,000 single filer threshold times 3%), and his allowed itemized deductions after the limitation are $114,000 ($120,000 minus $6,000).

    Medical Deduction—Although not part of the 2012 ATRA, beginning in 2013, the threshold for deducting medical expenses as an itemized deduction will increase from 7.5% to 10% of AGI. Taxpayers who are 65 and older, however, are granted an exception, and will still be able to deduct medical expenses that exceed 7.5% of their AGI.  The exception for taxpayers 65 and older will continue through 2016, and all taxpayers will be subject to the 10% threshold in 2017. 

    Personal Exemption Phase-out (“PEP”)—After a long hiatus, the phase-out of personal exemptions is also reinstated beginning with the 2013 tax year. Each personal exemption is set at $3,900 for 2013. Under this PEP calculation, a taxpayer’s personal exemptions will be reduced by 2% for each $2,500 (or portion thereof) by which the taxpayer’s AGI exceeds specific thresholds for his or her filing status. The threshold amounts are: $300,000 for joint filers, $275,000 for heads of households, $250,000 for single filers and $150,000 for married taxpayers filing separately. These thresholds will be adjusted for inflation for tax years after 2013.

    For example, Taxpayer B is entitled to the head of household filing status and claims personal exemptions for herself and her three children (4 times $3,900 or $15,600). Her AGI is $350,000, which exceeds her $275,000 filing status threshold by $75,000. When the phase-out calculation is applied ($75,000 divided by $2,500 times 2% equals 60%), she will lose 60% of her personal exemptions ($9,360), and will only be allowed to claim $6,240 of personal exemptions.

  4. Alternative Minimum Tax Exemption (“Patch”)—Previous temporary measures to deal with the contagion of the Alternative Minimum Tax (“AMT”) expired at the end of 2011, meaning that millions of additional taxpayers faced the prospect of paying the AMT on their 2012 returns. To prevent the unintended consequence of millions of middle-income taxpayers falling victim to the AMT, Congress once again applied a “patch” to the problem. The “patch” extends a provision allowing for an increased AMT exemption amount, but this time the patch is intended as a permanent fix.  Under the new law, for tax years beginning in 2012, the AMT exemption amounts have increased to: (1) $78,750 from $74,450 in the case of married individuals filing a joint return and surviving spouses; (2) $50,600 from $48,450 in the case of unmarried individuals other than surviving spouses; and (3) $39,375 from $37,225 in the case of married individuals filing a separate return. More importantly, these amounts will be indexed for inflation after 2012, meaning that annual “patches” will no longer be needed.  For 2013, the AMT exemption amounts are $80,800 for joint filers, $58,900 for single individuals and $40,400 for married individuals who file separate returns. 

    In addition to indexing the AMT exemption amount for inflation, the 2012 ATRA has also indexed the breakpoint for the 26% and 28% tax brackets, as well as the Alternative Minimum Taxable Income (“AMTI”) level at which point the exemption amount is phased out.  For 2012, the tax-rate breakpoint is set at $175,000 and the exemption phase-out begins once an individual’s AMTI exceeds $150,000. For 2013, the AMT tax rate breakpoint and the AMT exemption phase-out floor increase to $179,500 ($89,750 for married filing separately) and $153,900, respectively.

    By finally indexing the AMT exemption, the tax-rate breakpoint and the AMTI floor to inflation, the 2012 ATRA should slow the spread of the AMT burden that has been impacting millions of middle-income taxpayers over the past few years.

    Another provision in the Act provides AMT relief for taxpayers claiming personal tax credits. The tax liability limitation rules generally provide that certain nonrefundable personal credits (including the dependent care credit and the elderly and disabled credit) are allowed only to the extent that a taxpayer has regular income tax liability in excess of the tentative minimum tax, which has the effect of disallowing these credits against the AMT. Temporary provisions had been enacted that permitted these credits to offset the entire regular and AMT liability through the end of 2011. The new law extends this relief permanently.

  5. Estate, Gift, and Generation Skipping Tax Exemption and Rate—Under 2001 legislation, the estate, gift and generation skipping tax (“GST”) was phased out and fully repealed in 2010, putting in its place a modified carryover basis regime.  However, 2010 legislation reinstated the estate and GST tax, setting an exemption of $5 million per person and a top tax rate of 35% through 2012. The exemption amount was indexed for inflation, and the exemption for 2012 was $5.12 million per person. The 2010 legislation also introduced the concept of portability for deaths after 2010.  Portability allows a surviving spouse to use any unused exemption of the deceased spouse in the surviving spouse’s estate.

    The 2012 ATRA eliminates the sunset provision and makes the $5 million exemption permanent (indexed for inflation). The 2013 indexed exemption is $5,250,000.  Moreover, the concept of portability was made part of the permanent tax law.

    The Act did, however, increase the top tax rate from 35% to 40%. Under the existing sunset provisions, the top tax rate would have increased to 55%, and the exemption would have dropped to $1 million.  

    Regarding the gift tax, the $5 million lifetime gift tax exemption (indexed for inflation) was also scheduled to revert to $1 million after 2012. The 2012 ATRA makes the $5 million lifetime exemption permanent (indexed for inflation), again unifying the estate and gift tax regimes on a permanent basis. Prior to 2001, the two regimes were unified, and were decoupled for the 2001–2010 period.  

    Previously, certain commentators raised a potential risk of a “clawback” of prior taxable gifts if the exemption were to revert to $1 million. That concern is negated by the “permanent” indexed exemption provision.

    A summary of the exemption amount and the top tax rate follows:

    Estate, Gift & GST Regimes

    Year

    Exemption

    Top Tax Rate

    2011

    $5,000,000

    35%

    2012

    $5,120,000

    35%

    2013

    $5,250,000*

    40%

    2014 & Future

    Indexed for Inflation

    40%

    *The 2013 exemption amount of $5,250,000 equates to a unified credit equivalent of $2,045,800.

    Notwithstanding the unification of the estate and gift tax system, the basic math almost always favors a lifetime gift as opposed to holding the property until death (income tax basis rules ignored). For a rough example, assume a marginal $1 million investment portfolio. If $714,000 is transferred as a gift during lifetime (and assuming the lifetime gift exemption has already been used), the taxpayer will pay about $286,000 of gift tax, thus reducing the portfolio in the hands of the taxpayer to $0. On the other hand, if the $1 million portfolio is held until death, the estate tax would be $400,000, with $600,000 left for the family, an amount that is clearly lower than the $714,000 the family would receive through a lifetime gift. The reason: the gift tax is exclusive (it does not calculate the tax including the gift tax due), while the estate tax is inclusive (it does calculate the tax including the estate tax due). 

    Interestingly, the Act does not include any provisions related to the current administration’s proposals to restrict the use of grantor retained annuity trusts (“GRATs”), to eliminate sales to intentionally defective trusts by making grantor trusts includable in one's taxable estate, to restrict the use of valuation discounts or to eliminate the use of dynasty trusts by restricting the GST exemption period to 90 years. Thus, these techniques continue to be viable alternatives for planning one’s estate.

    The following is a summary of the new estate, gift and GST tax rates:

    2013 Estate, Gift, and GST Tax Rates

    $0–$100,000

    Varies From

    18%–28%

    $100,001–$150,000

    30%

    $150,001–$250,000

    32%

    $251,001–$500,000

    34%

    $500,001–$750,000

    37%

    $750,001–$1,000,000

    39%

    $1,000,001 +

    40%

  6. Extension of Miscellaneous Tax Provisions—The Act extended, with certain modifications and for various durations, a number of tax provisions that will impact individual taxpayers. Some of these provisions expired at the end of 2012, while others expired at the end of 2011 and are being extended retroactively to the beginning of 2012.

    Credits and other provisions that have been extended permanently include:

    • Earned Income Tax Credit
    • Child Tax Credit
    • Dependent Care Tax Credit
    • Adoption Tax Credit and employer-provided adoption assistance program exclusion
    • Employer-Provided Childcare Tax Credit
    • Nonbusiness Energy Property Credit for qualified energy-efficient improvements and residential energy property expenditures.
    • Coverdell Education Savings Accounts
    • Qualified tuition deduction
    • Student loan interest deduction
    • Exclusion from income for employer-provided education assistance
    • Exclusion from income for certain scholarships

    The American Opportunity Tax Credit for college tuition and related education expenses, which may result in a credit of up to $2,500 for each of the first four years of post-secondary education, has been extended for five years, through 2017.

    Other credits and provisions that have been extended only through 2013, when they will once again expire, include:

    • Deduction for mortgage insurance premiums (PMI)
    • Option to deduct state and local general sales taxes
    • Above-the-line deduction for qualified tuition and related expenses
    • Deduction for certain expenses of elementary and secondary school teachers
    • Exclusion for discharge of qualified principal residence indebtedness

    • Special rule for charitable contributions of real estate conservation easementsprincipal residence indebtedness

  7. Tax-Free Distributions from IRAs—The 2012 ATRA temporarily extends existing tax law, which had expired at the end of 2011, so taxpayers age 70 ½ or older may continue to make tax-free distributions from their individual retirement accounts (“IRAs”) directly to qualifying charities. The extension is through the 2012 and 2013 tax years. This means that taxpayers who (in anticipation of retroactive extensions of the law) made direct transfers from their IRAs to qualifying charities during 2012 may qualify those transfers for favorable tax treatment. Furthermore, because 2012 has already passed, the 2012 ATRA provides two special provisions in the area of qualified charitable distributions. First, an eligible taxpayer who received a distribution after November 30, 2012, but before January 1, 2013, may treat any portion of the distribution as a qualified charitable distribution provided, (i) such portion is transferred in cash, after the distribution, to a qualified charitable organization before February 1, 2013, and (ii) such portion is not more than the $100,000 annual distribution limitation. Second, another special rule deems distributions made after December 31, 2012, and before February 1, 2013, as being made on December 31, 2012. Therefore, those taxpayers who waited patiently, hoping that the qualified charitable distribution provision would be extended for 2012, only to be disappointed when December 31, 2012, passed without passage of an extenders package, now have a short window during the month of January, 2013, in which to make a charitable gift from their IRAs that will be treated as a 2012 distribution.

  8. New Medicare Tax on Earned and Unearned Income—Although not part of the 2012 ATRA, taxpayers will be subject to an additional tax burden beginning in 2013 in the form of a Medicare tax, legislated under the Patient Protection and Affordable Care Act (“PPACA”). Although the PPACA was signed into law over two years ago, it contains several revenue provisions that will affect individual taxpayers beginning in 2013.

    Beginning in 2013, the Medicare payroll tax will increase by 0.9% on the earned income (wages and self-employment income) of single and married filing jointly taxpayers in excess of $200,000 and $250,000, respectively. The increased Medicare tax applies to employees only, not to employers. Accordingly, the increased Medicare tax rate on wages over the $200,000/$250,000 thresholds will be 2.35% (increased from 1.45%) and the increased Medicare tax rate on self-employment income over the $200,000/$250,000 thresholds will be 3.8% (increased from 2.9%). The $200,000 threshold for single taxpayers and the $250,000 threshold for married taxpayers filing jointly are not indexed for inflation, so it is possible that a greater number of taxpayers will be subject to this tax increase in subsequent years.

    Employers will apply the increased 0.9% Medicare tax when wages exceed $200,000, regardless of the employee’s filing status or wages paid by another employer. Married taxpayers who individually earn less than $200,000 but jointly earn more than the threshold amount (i.e., more than $250,000 together) will pay additional Medicare taxes through increased withholding adjustments, estimated tax payments or when they file their 2013 Forms 1040.

    Effective in 2013, the PPACA imposes a 3.8% Medicare surtax on the unearned income of single taxpayers with Modified Adjusted Gross Income (“MAGI”) in excess of $200,000 and joint taxpayers with MAGI in excess of $250,000. For the purpose of this tax, MAGI is comprised of AGI plus foreign earned income. This new tax is noteworthy, as this is the first time, since its implementation in 1966, that Medicare taxes have ever been applied to anything other than wages and self-employment income.

    The Medicare surtax will be imposed on the lesser of a taxpayer’s unearned income or the excess of the taxpayer’s MAGI over the specific MAGI filing status threshold. For example, a single taxpayer with a MAGI of $230,000 ($30,000 over the threshold) and $50,000 of unearned income will pay the 3.8% tax on $30,000. Similarly, joint taxpayers with a MAGI of $400,000 ($150,000 over the threshold) and $40,000 of unearned income will pay the 3.8% tax on $40,000.

    Sources of unearned income subject to this Medicare tax include interest, dividends, capital gains, annuities, royalties and passive rental income. Tax-exempt interest and distributions from retirement plans—(401(k) Plans, IRAs, Roth IRAs, Profit Sharing Plans and Defined Benefit Plans)—are not subject to the 3.8% Medicare surtax. 

     The Medicare tax rates at applicable AGI levels are as follows:  

    2013 Medicare Tax Rates

    Modified Adjusted Gross Income (MAGI)

    Single Taxpayers

    Joint Filers

    Earned

    Income*

    Net Investment

    Income

    $0–$200,000

    $0–$250,000

    1.45%

    0%

    $200,001+

    $250,001+

    2.35%

    3.8%

    *For self-employed individuals, the rate up to $250,000/$250,000 is 2.9% and 3.8% for amounts in excess of these thresholds.

  9. Other Provisions—The 2012 ATRA did not extend the payroll tax holiday that applied to the 2011 and 2012 tax years. For the past two years, employees paid a 4.2% FICA tax on their wages up to the Social Security limit ($110,100 for 2012), a 2% reduction from the normal 6.2%. Many commentators feel that this will be the one provision in the Act that will have the most impact on taxpayers.

     ATRA includes a number of business tax breaks. The Act extends the additional first-year depreciation deduction known as bonus depreciation for one year. In general, 50% of the adjusted basis of qualified property acquired in 2013 may be claimed as bonus depreciation. Moreover, the first-year depreciation for autos and trucks acquired in 2013 is also enhanced by an additional $8,000 depreciation deduction, extending the rule that was to sunset at the end of 2012.

    The Act also retroactively increases the maximum Section. 179 expensing amount (in lieu of depreciation) to $500,000 for tax years 2012 and 2013, with a phase-out if total investment in depreciable assets exceeds $2 million.

    There are a number of other business tax provisions in the 2012 ATRA that are beyond the scope of this alert. 

Conclusion:

The Act provides some clarity for planning purposes.  On the horizon is the next battle, which would be an agreement on the expenditure side of the equation.  Please stay tuned!

Download Alert

Posted at 9:00 AM by makeenan@nixonpeabody.com | Category: Individual Tax | Permalink | Email this Post | Comments (0)

6/14/2012

IRS issues cloudy clarification of vesting rules

6/7/2012

Open PDF: IRS issues cloudy clarification of vesting rules

The IRS recently issued regulations clarifying the answers to some long-standing questions regarding the taxation of restricted stock. However, these clarifications do not answer and indeed may raise new questions concerning the IRS positions on certain cash-based deferred compensation vesting issues.

Section 83 of the Internal Revenue Code governs the taxation of a transfer or grant of restricted property, typically stock, as compensation. (Separate tax rules, including Sections 409A, 457, and 457A, apply to cash-based deferred compensation.) 

In general, the transfer of stock or other property is only taxable when the property is no longer subject to a “substantial risk of forfeiture.” A typical vesting restriction is service-based, e.g., the granted stock is forfeited if the recipient terminates service before a specified number of years have elapsed. Whether other non-service types of restrictions are effective to defer taxation has always been determined based on the facts and circumstances. The IRS has now clarified under what circumstances non-service restrictions would be considered a substantial risk of forfeiture.

First, the IRS has clarified that any non-service based vesting condition must be “related to the purpose of the transfer.” For example, a vesting condition based upon the company achieving a specified level of earnings would be a condition related to transfer or grant of the company stock.

Second, the likelihood of the forfeiture occurring and the likelihood that the forfeiture will be enforced must be considered. For example, if stock is granted subject to a condition that the stock is forfeited if the gross receipts of the employer fall by 90% over three years, the likelihood of such a percentage fall must be considered. If the employer were a long-standing seller of a product and there was no indication that there would either be a fall in demand or an inability of the employer to sell the product, the IRS would take the position that the transfer was taxable when granted, rather than after the three-year period had elapsed.

Third, a mere restriction on transferring the stock does not create a substantial risk of forfeiture, even if the stock would be forfeited if the employee attempted to transfer it. For example, if an employee is awarded stock subject only to the condition that the employee not sell or otherwise transfer the stock for five years, the stock is taxable at the time of transfer, even if the recipient were to forfeit the stock if he or she did attempt such a transfer.

Also, the regulations now clarify that the only provision of the securities law that delays taxation under Section 83 is Section 16(b) of the Securities Exchange Act. Section 16(b) restricts “certain” insiders from selling their company stock within six months of a covered purchase of company stock. Other types of transfer restrictions in connection with securities transactions, such as restrictions imposed by lock-up agreements or restrictions related to fraudulent or deceptive insider trading under Rule 10b-5 of the Exchange Act, will not cause the stock to be substantially unvested.

These clarifications under Section 83 are not particularly new, and were foreshadowed in prior IRS rulings. However, other tax deferral techniques are also dependent on whether there is a vesting condition that is a “substantial risk of forfeiture.” In particular, Sections 409A and 457A use the same phrase to determine the taxation of deferred compensation. Moreover, for executives of tax-exempt organizations, Section 457(f) determines whether a potential deferred compensation arrangement is taxable based on when it is subject to a “substantial risk of forfeiture.”

Even though the phrase “substantial risk of forfeiture” is in each of these statutes, the IRS has so far not chosen to interpret the phrase identically. For example, the IRS has said that a covenant not to compete never results in a substantial risk of forfeiture under Section 409A, but may in limited circumstances qualify as a substantial risk of forfeiture under Section 83. The IRS has also previously announced an intention to issue final regulations on Section 457(f) that would interpret this phrase, but not necessarily in a manner identical to other tax code sections. As a result, when designing non-service-based vesting restrictions for deferred compensation arrangements, employers need to be careful in comparing and contrasting the alternative meanings of the phrase “a substantial risk of forfeiture.”

The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.

Posted at 5:23 PM by makeenan@nixonpeabody.com | Category: Individual Tax | Permalink | Email this Post | Comments (0)

1/12/2012

Don’t sign that closing agreement yet! IRS taxpayer advocate says some offshore account FBAR penalties are too high

January 11, 2012

A recently-disclosed exchange of correspondence between the top management of IRS and the head of the Taxpayer Advocate Service (TAS) has raised the hopes of many taxpayers that there may be some relief for the high cost of participating in the offshore account voluntary compliance initiatives. Are you eligible for lower FBAR penalties?

Click here to read the full article on nixonpeabody.com.

For further information, contact your Nixon Peabody attorney or:

Posted at 11:58 AM by tking@nixonpeabody.com | Category: Individual Tax; Tax Controversy; Corporate Tax | Permalink | Email this Post | Comments (0)

9/14/2010

IRS Notice on Economic Substance
By Forrest Milder
 
Over the years, several theories have been applied by the courts in considering whether a transaction was undertaken for tax avoidance reasons so that the transaction should not be “respected” as a matter of federal income tax law.  Courts differed in how they considered this issue and which tests they applied.  Some in government thought there should be a uniform standard for the application of these tests, often referred to as the “economic substance doctrine”, and in March, 2010, Congress passed, and the President signed into law, the “Health Care and Education Affordability Reconciliation Act of 2010  .Part of the 2010  Act included the “codification” of the economic substance doctrine in Section 7701(o) of the Internal Revenue Code.   The new law is effective for transactions entered into after March 30, 2010.
 
On September 13, 2010,the IRS published a notice on the new economic substance doctrine that is found in Section 7701(o).  In my humble opinion, it is remarkable in its failure to actually say anything "new".  It largely recites the statute, and then says that the IRS will rely on existing authorities to interpret the applicable tests.
 
As a quick refresher of the rules and commentary on the notice --
 
(1) 7701(o) has a two part test -- (A) the transaction must change, in a meaningful way (apart from tax effects) the taxpayer's economic position, and (B) the taxpayer must have a substantial purpose (apart from Federal income tax effects) for entering into the transaction.  The IRS makes clear that this is a "conjunctive test", by which they mean to remind taxpayers that BOTH tests must be passed. 
 
(2) The notice mentions the provision of section 7701(o) stating that these rules apply only if "economic substance is relevant to a transaction", although it provides no additional guidance on that issue.
 
(3) If the taxpayer wants to rely on "profit" as a motivation, the computation must be based on the present value of the pre-tax profit.
 
(4) A 40% penalty will apply, rather than a 20% penalty, if the taxpayer does not disclose the transaction on his/her/its return.  The notice states which forms should be used.
 
(5) Under regulations to be issued, foreign taxes will be considered in determining pre-tax profit.
 
(6)  As I noted above, the notice includes words like"the IRS will continue to rely on relevant case law" throughout.
 
(7)  The notice does not mention tax credits, or other congressionally-favored tax incentives .  Some will remember that footnote 344 of the Technical Explanation that accompanied the Act included a sort of "savings provision", suggesting that these rules did not apply to transactions which featured those Congressionally favored tax provisions.  So, we seem to still be awaiting guidance on that front.
 
For more information, please contact Forrest Milder at 617-345-1055 or fmilder@nixonpeabody.com.
 
 
Posted at 3:09 PM by lmozlin@nixonpeabody.com | Category: Corporate Tax; Estate Tax; Gift Tax; Individual Tax; Partnerships & Funds; Tax Controversy | Permalink | Email this Post | Comments (0)

4/21/2010

What does codification of the Economic Substance Doctrine mean for tax credit transactions?

By Forrest David Milder

The IRS has contended, and many courts have agreed, that a transaction should be disregarded for federal income tax purposes if it was undertaken to accomplish tax avoidance. Application of this standard has not been uniform. The courts have considered one or more of the following questions—Does the taxpayer have a reason for undertaking the transaction other than tax considerations? Can the taxpayer demonstrate a non-tax “business purpose”? Does the taxpayer have a reasonable prospect of making a “profit” from the transaction?

Whether it was a desire for a uniform standard or merely a way to raise federal revenues, new Section 7701(o), which “codifies” the “economic substance doctrine,” became law in March 2010, as part of the “Health Care and Education Affordability Reconciliation Act of 2010” (the “2010 Reconciliation Act”). The new law is effective for transactions entered into after March 30, 2010, and it provides both a definition of economic substance, and a penalty that may apply if a taxpayer enters into a transaction that fails to have economic substance. 

If a tax credit transaction is found to not have “economic substance,” then some or all of the credits and related deductions will be disallowed. In addition, either a 20% penalty will apply if the transaction is disclosed on the taxpayer’s return, or a 40% penalty if it is not. Of course, for disclosed transactions, this is the same rate as the substantial understatement penalty, so the additional cost of the new rules may not actually yield larger penalties.

This brings us to the definitional part of the analysis.

The statutory provision is rather terse. For any transaction to which the economic substance doctrine is relevant, the transaction will be treated as having “economic substance” only if (1) the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position, and (2) the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into such transaction. A transaction’s “profit potential” may be taken into account in determining whether a transaction meets this second test, but only if the present value of the expected pre-tax profit from the transaction is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction was respected. In doing this computation, fees, and other transaction expenses are taken into account as expenses in determining pre-tax-profit. 

So, we begin with the question of whether the economic substance doctrine is even “relevant,” and if it is, we next consider whether it results in a “meaningful” change that is “economic,” but not on account of federal income tax. Finally, we consider the taxpayer’s purpose, looking for something “substantial,” other than federal income tax, noting that we may take profit motive into account only if the present value of the pre-tax profit, after taking into account transaction expenses, is substantial when compared to the present value of the anticipated tax benefits. Note the complexity of this last test—if a taxpayer has a substantial motivation that is not related to profit, then the test is passed, but if the motivation is instead based on the pre-tax potential for profit, then that potential must be substantial when compared to the tax benefits, all computed on a present value basis.

This may sound troublesome in many tax credit motivated transactions, i.e., those where the taxpayer takes tax credits into account as part of the anticipated return, with any anticipated cash being small when compared to the credits. For example, imagine a $1 million investment that yields a $1 million tax credit in year one, five years of MACRS depreciation, and a $50,000 cash payment in year 6, when the investor sells his interest and leaves the transaction. Is $50,000, paid six years from now, “substantial” when compared to $1m of tax credits today, plus the value of five years worth of depreciation deductions? Or, suppose a somewhat more cash-driven case in which the taxpayer expects to receive $20,000 in cash for each of the next 20 years, followed by a $200,000 payment in year 21. While $600,000 in payments may be “substantial” in an absolute sense, this declines significantly, to about $195,000 at a 10% discount rate, or $320,000 at a 5% rate. Are these numbers still “substantial” when compared to the tax benefits that have a present value of more than $1,250,000 at either discount rate?

Fortunately, there is a savings feature for tax credit transactions.

The Joint Committee on Taxation prepared the “Technical Explanation of the Revenue Provisions of the ‘Reconciliation Act of 2010,’ as amended, in combination with the ‘Patient Protection and Affordable Care Act’” (the “Technical Explanation”). It provides that the codification is not intended to change current law standards in determining when to utilize an economic substance analysis, and it is not intended to alter the tax treatment of certain basic business transactions that, under longstanding judicial and administrative practice are respected, merely because the choice between meaningful economic alternatives is largely or entirely based on comparative tax advantages. 

More important to the tax credit community is footnote 344 of the Technical Explanation. It provides an important rule for tax credit transactions:

If the realization of the tax benefits of a transaction is consistent with the Congressional purpose or plan that the tax benefits were designed by Congress to effectuate, it is not intended that such tax benefits be disallowed. See, e.g., Treas. Reg. sec. 1.269-2, stating that characteristic of circumstances in which an amount otherwise constituting a deduction, credit, or other allowance is not available are those in which the effect of the deduction, credit, or other allowance would be to distort the liability of the particular taxpayer when the essential nature of the transaction or situation is examined in the light of the basic purpose or plan which the deduction, credit, or other allowance was designed by the Congress to effectuate. Thus, for example, it is not intended that a tax credit (e.g., section 42 (low-income housing credit), section 45 (production tax credit), section 45D (new markets tax credit), section 47 (rehabilitation credit), section 48 (energy credit), etc.) be disallowed in a transaction pursuant to which, in form and substance, a taxpayer makes the type of investment or undertakes the type of activity that the credit was intended to encourage.

Accordingly, it appears that transactions that feature the typical tax credits will generally not be subjected to economic substance analysis.

We shouldn’t expect every credit transaction to get a free pass on the economic substance test. Even under the footnote, transactions must be “consistent with the Congressional purpose or plan that the tax benefits were designed by Congress to effectuate.” Accordingly, a transaction may still be at risk if it includes additional parties, fees, or arrangements that go beyond the Congressional purpose or plan. Indeed, the Technical Explanation specifically approves of “bifurcating” a transaction to address the disallowance of tax-avoidance objectives that have been combined with non-tax objectives. Furthermore, footnote 344 refers only to “tax credits” not being disallowed; it does not indicate what the treatment should be for related tax items, such as depreciation or interest expense.  Finally, transactions involving the recent grant programs, like Section 1602 for housing, and 1603 for renewables, resemble tax credit transactions in many ways, but it’s not clear that they are eligible for the benefits of footnote 344, which refers specifically to credits.

We expect that a typical tax opinion will now feature a discussion of how the particular investment complies with the rules of new Section 7701(o) so as to meet the requirements of “Circular 230.”  It should be noted that some tax advisors have expressed concern about relying on a footnote in a “technical explanation” produced by the Joint Tax Committee in writing a tax opinion. However, this seems unlikely to be a problem; both case law and Treasury regulations give substantial deference to Joint Tax Committee explanations.

Relying on the footnote, and noting that the project has (i) produced units of affordable housing in compliance with a “qualified allocation plan” in the case of housing projects, (ii) rehabilitated an historic structure in compliance with the rules of local historic preservation offices and the United States Parks Service in the case of historic projects, (iii) developed a project in a poor community that (typically) employs low-income persons in compliance with the rules of the CDFI Fund and the award of new markets tax credits to the CDE in the case of new markets tax credit projects, or (iv) established and operated a renewable energy facility to save energy resources in compliance with the congressional objective to reduce America’s reliance on conventional fuels, it shouldn’t be hard to demonstrate consistency with a congressional purpose or plan. Of course, energy credit transactions do not have a third party or governmental approval process like the others, but it should nonetheless be possible to cite to the anticipated benefits of the energy tax credit that encourages the construction and operation of renewable energy facilities.

Still, it is important to scrutinize the actual business deal, which is where we will compare the economic and tax benefits. For example, notwithstanding footnote 344, should a transaction with unreasonable fees still be respected as having “economic substance”? And, as noted above, adding additional “features” to a transaction may ultimately “distort the liability of the particular taxpayer.”  So,  be sure to have any credit transaction reviewed by your professional tax advisor.

Finally, are the cash distributions associated with historic and some renewable transactions now superfluous in view of the congressional purpose or plan of rehabilitating historic structures or generating renewable energy? As of now, tax advisors are treating the economic substance rules as an additional test, and not something that might lessen the standards that applied before the test became law. Of course, this may change.

The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.

For further information, contact your Nixon Peabody attorney or:
Posted at 5:12 PM by lmozlin@nixonpeabody.com | Category: Corporate Tax; Individual Tax; International Tax | Permalink | Email this Post | Comments (0)

4/7/2010

New Medicare taxes deliver a blow to private equity funds, new economic substance laws also of concern

By Christian M. McBurney and Sarah A. Nelson

The Health Care and Education Affordability Reconciliation Act of 2010 (the “Act”), signed by President Obama on March 31, 2010, includes a number of revenue-raising provisions that will adversely affect private equity investors and fund managers. These tax increases are on top of the expected expiration of the “Bush tax cuts,” which, after the end of this year, absent action by Congress, would automatically result in the increase of (i) the current maximum rate of 15% on capital gains and dividends to 20%, and (ii) the current maximum rate of 35% on regular ordinary income to 39.6%. In addition, while “carried interest” legislation was ultimately not included in the Act, it is still possible that Congress could enact it in the near term and thereby convert the treatment of capital gain allocable to fund managers to ordinary compensation income.

2.9% Medicare tax increase on wages and self-employment income

Starting with income received after December 31, 2012, the Act increases by .9% the Medicare tax from its current rate of 2.9% to 3.8% on an individual’s wages as an employee and self-employment income in excess of $250,000 (married filing jointly) or $200,000 (individual). Unlike current FICA and Medicare taxes, this additional tax is imposed solely on the employee and self-employed worker, and is not deductible. Employers will have, however, certain withholding obligations with respect to the Medicare tax increase.

3.8% Medicare tax imposed on individual net investment income

The Act modifies the Medicare tax to include a tax on individual’s, trust’s and estate’s net investment income. Currently, Medicare is not subsidized by a levy against net investment income and is financed primarily by payroll taxes.

Implementation of the Medicare tax. Beginning in 2013, the Act imposes a tax of 3.8% on the lesser of (i) annual net investment income or (ii) the excess of modified adjusted gross income (AGI) over the threshold amount ($250,000 in the case of a joint return, or $200,000 in the case of a single return). Net investment income is defined as:

  • Gross income from interest, dividends, royalties, and rents;
  • Net gains from the disposition of property, such as the sale of stocks, bonds, and real estate;
  • Gross income derived from a business constituting a passive activity to the taxpayer (including operating income and gain on sale from an operating business that flows up to the taxpayer-investor in a fund that is taxed as a partnership for income tax purposes); and
  • Gross income derived from a trade or business comprised of trading in financial instruments or commodities (whether or not the taxpayer is active in the business).

Gain from the sale of a partnership interest or stock in an S corporation is taken into account as if the entity had sold all of its properties at fair market value immediately before the disposition. Net investment income is reduced by properly allocable deductions to such income, including passive losses that offset passive gain.

The tax does not apply to income from, or gain on the sale of, a business, where the taxpayer is an active participant. The Medicare tax also does not apply to nonresident aliens, trusts that are exempt under Code section 501, and certain other charitable trusts. Moreover, the Medicare tax does not apply to distributions from qualified retirement plans, tax-exempt bonds, and gain on the sale of a residence to the extent excluded from income.

Examples

Example 1: For tax year 2013, Investor X (married filing jointly) has $275,000 of net unearned income (interest and dividends less any allowable deductions). Investor X also has $500,000 of W-2 income. The Medicare tax is calculated as follows: 3.8% times the lesser of (a) $275,000 (net investment income) and (b) $775,000 (modified AGI) minus $250,000 (threshold amount). This results in a tax of $10,450 (3.8% of Investor X’s net investment income).

Example 2: For tax year 2013, Investor Y (married filing jointly) has $255,000 of net investment income and $125,000 of W-2 income. The Medicare tax is calculated as follows: 3.8% times the lesser of (a) $255,000 (net investment income) and (b) $380,000 (modified AGI) minus $250,000 (threshold amount). This results in a tax of $4,940 (3.8% of the excess of Investor Y’s modified AGI less the threshold amount).

How the Medicare tax impacts private equity investors and fund managers. Investors in private equity funds will feel the impact of the additional 3.8% Medicare tax, including on disposition gains previously taxed at low capital gains rates. Carried interest from the sale of underlying portfolio companies allocated to fund managers, which is currently taxed at a favorable capital gains rate, will now also be subject to the 3.8% Medicare tax. U.S. investors in and managers of hedge funds where active trading of financial instruments or commodities is conducted will be subject to the 3.8% tax hike. While U.S. investors could shield this type of trade or business income from the Medicare tax by investing through a corporation, it would seem that the resulting double taxation would still make a corporation less tax-efficient than the typical pass-through structure (note that dividends from a corporation are also subject to the new Medicare tax to the extent the taxpayer’s AGI exceeds the threshold amount). Foreign investors who are nonresident aliens for U.S. federal income tax purposes will continue to be exempt from U.S. tax on their portfolio income if they invest through a blocker entity and will also be exempt from the Medicare tax even if they invest directly in a U.S. fund taxed as a partnership.

As the Medicare tax does not go into effect until 2013, there is time for some tax planning. Funds could consider selling “winners” in 2010 (while the low maximum 15% capital gains rate remains in effect and before the rate increases to 20%) or in 2011 or 2012 (before the new 3.8% Medicare tax takes effect, increasing the top capital gains rate to 23.8%). Additionally, investment income can be sheltered by any passive losses. It appears that passive losses that are not used to offset investment income can be carried forward to offset investment income in a future year. How the carry-forward will work in all circumstances is unclear. For example, it is not certain whether passive losses that a taxpayer carries forward from years previous to 2013 may be carried forward.

Addition of economic substance legislation

The Act adds new Section 7701(o) to the Code, which could adversely affect how private equity funds dispose of their portfolio companies. In general, new section 7701(o) provides that a taxpayer whose facts otherwise satisfy the technical legal requirements for a tax benefit shall be denied that tax benefit if in the opinion of the IRS (a) the taxpayer was motivated to arrange the transaction for the purpose of obtaining that tax benefit, (b) the benefit was not among the purposes Congress had contemplated in enacting the pertinent statute, and (c) the taxpayer fails to prove satisfaction of the economic substance test once the IRS asserts its application. A transaction that is properly challenged by the IRS will be treated as having economic substance only if (1) the transaction changes in a meaningful way (apart from U.S. federal income tax effects) the taxpayer’s economic position, and (2) the taxpayer has a substantial purpose (apart from U.S. federal income tax effects) for entering into such transaction.

The judicial “economic substance” doctrine has existed for many years and new section 7701(o) is not intended to depart radically from that judicial doctrine. The most important feature of section 7701(o) is its penalty regime. In general, if a taxpayer is found to have violated section 7701(o), a 20% penalty is imposed on the amount of underpaid tax. The penalty is increased to 40% if the transaction is not adequately disclosed on the taxpayer’s timely-filed tax return. There is no exception for reasonable reliance on a tax opinion or other reasonable cause or good faith, as was the case under prior law.

In the past, the economic substance doctrine has been applied most frequently in perceived “tax shelter” cases. On occasion, in the late 1990s and early 2000s, a few private equity funds engaged in such a transaction in disposing of a portfolio company or permitted the portfolio company to engage in such a transaction. The IRS successfully challenged many of these “tax shelter” transactions. With the new penalty regime, the stakes are higher for taxpayers.

There has been concern expressed in a few quarters that a tax-exempt investor’s use of a “blocker” entity that is taxed as a C corporation could run afoul of new section 7701(o). The application of section 7701(o) to this common planning technique would certainly be a surprisingly result. Given the harsher penalty regime, this and other areas might be appropriate for the IRS to resolve by issuing express guidance. There is case law supporting a taxpayer’s ability to make a “check-the-box” election under the IRS’s own regulations, regardless of the taxpayer’s tax planning motives.

Clients are encouraged to consult their tax advisors if there is any doubt that a proposed transaction could violate the new economic substance law.

To ensure compliance with IRS requirements, we inform you that any federal tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed in this communication.

For more information on this issue or any private equity matter, please contact your regular Nixon Peabody attorney or:

Posted at 9:23 AM by lmozlin@nixonpeabody.com | Category: Partnerships & Funds; Individual Tax | Permalink | Email this Post | Comments (0)

11/17/2009

New IRS Group to Target High Wealth Individuals
By Amanda Pugh
 
IRS Commissioner Douglas Shulman announced the recent formation of a new unit of the Internal Revenue Service, dubbed the Global High Wealth Industry Group, which will focus on the nation’s wealthiest individuals and their entities. “We will take a unified look at the entire web of business entities controlled by a high-wealth individual, which will enable us to better assess the risk such arrangements pose to tax compliance and the integrity of our tax system,” Shulman said in his speech to the American Institute of Certified Public Accountants.
 
Some criteria that are likely to raise a red flag for an audit are:
 
1. Assets or Income of $10 Million or Greater - Shulman pointed out that “at least initially, [the IRS] will be looking at individuals with tens of millions of dollars of assets or income.”   The group of taxpayers with $10 million or more in income is relatively small - just .05% of all tax returns received in 2007.  Large bonuses or retirement packages can cause additional taxpayers to fall into this group.  Taking into account taxpayers with significant assets (as opposed to income) will greatly greatly expand the target group.
 
2. Complex Financial Arrangements - Shulman said “They may include trusts, real estate investments, royalty and licensing agreements, revenue-based or equity-sharing arrangements, private foundations, privately-held companies, and partnerships and other flow-through entities that require looking at the entire, and often huge, spectrum of transactions and entities. A single high-wealth individual may have actual or beneficial ownership of numerous related entities, sometimes alone and sometimes along with other family members or business associates." Therefore, according to a wealth advisor, you will likely be at more risk if you have substantial wealth, dual citizenship and assets in another country, are a legal resident alien (i.e., you do not have U.S. citizenship, but are working or living in the U.S. temporarilty), or have assets outside of the U.S. 

3. Offshore Income or tax residency - Other tax considerations include “international sourcing of income and tax residency, and offshore structures and bank accounts,” Shulman said.
 
4. Movie and rock stars, athletes, expats -  Individuals in these and other similar professions will have an increased likelihood of being scrutinized due to having a high amount of income being earned overseas.
 
Any of these factors will put a taxpayers at a higher risk of an audit by the IRS. Further, under this new approach, there is the likely possibility that once the taxpayer is individually on the IRS' radar, it could also lead the IRS to audit the taxpayer's businesses as well.   
 
For more information, please contact:
Posted at 1:36 PM by lmozlin@nixonpeabody.com | Category: Individual Tax; Tax Controversy | Permalink | Email this Post | Comments (0)

11/5/2009

Employee vs. Independent Contractor Audits Are Taking Center Stage Again

By Christian McBurney

Earlier this year the Treasury Inspector General for Tax Administration issued a report recommending that the IRS create an agency-wide employment tax program to address the issue of worker classification and to conduct a compliance study to measure the impact of worker misclassification on the tax gap.  Starting this month, November 2009, the IRS will begin conducting random audits as part of this program.  The IRS recently announced that 6,000 companies will be audited and that they have hired and trained approximately 200 new agents to work on employment tax issues.  This is expected to be the most comprehensive IRS examination of employment tax compliance since 1984, with the main focus on whether businesses are properly classifying their workers as employees or independent contractors.  Companies that have not considered this issue recently should spend time analyzing their circumstances. 

In addition to this effort at Treasury, it is still possible that legislative action in this area could occur later this year, although not until Congress has completed action on health care reform.  In July, Rep. Jim McDermott (D-WA) introduced H.R. 3408 to clarify the rules classifying workers as independent contractors versus employees to ensure proper tax filing.  It would replace Section 530 with a new safe-harbor provision that fewer taxpayers could satisfy and whose protections would be retroactive in nature.  There has been no further activity on H.R. 3408 since it was referred to the House Ways and Means Committee.  We will continue monitoring this area.

For more information, please contact Christian McBurney at (202) 585-8358 or cmcburney@nixonpeabody.com
 
Posted at 8:05 PM by pdisangro@nixonpeabody.com | Category: Corporate Tax; Tax Controversy; Partnerships & Funds; Individual Tax | Permalink | Email this Post | Comments (0)

8/17/2009

Hawaii Announces Voluntary Disclosure Program for Offshore Accounts
By Ken Silverberg
 
The attached Tax Information Release 2009-03 describes a program just launched by Hawaii to formally parallel the IRS's offshore account initiative. Although everyone making the disclosures to the IRS is well advised to follow up with their respective state income tax authorities, most taxpayers have probably put that on the back burner. Hawaii is in the throes of a deep budget crisis, and apparently doesn't want to wait for the IRS information-sharing data. Their program establishes the state's September 23 deadline for notification.
 
We're surprised more states have not already done something like this, and predict others will do so as the IRS deadline approaches.
Posted at 6:09 PM by wcook@nixonpeabody.com | Category: Foreign Account Tax; Individual Tax; State and Local Tax | Permalink | Email this Post | Comments (0)
1 - 10 Next

Copyright © 2008 Nixon Peabody LLP. All rights reserved.   Terms of Use